Category Archives: currency forecasts

The European Central Bank (ECB) experiment with negative interest rates has not occurred in a vacuum. The concept has been discussed with special urgency since 2008 in academic and financial circles.

Recently, Larry Summers and Paul Krugman have developed perspectives on the desirability of busting through the zero bound on interest rates to help balance aggregate demand and supply at something like full employment.

If all central bank liabilities were electronic, paying a negative interest on reserves (basically charging a fee) would be trivial. But as long as central banks stand ready to convert electronic deposits to zero-interest paper currency in unlimited amounts, it suddenly becomes very hard to push interest rates below levels of, say, -0.25 to -0.50 percent, certainly not on a sustained basis. Hoarding cash may be inconvenient and risky, but if rates become too negative, it becomes worth it.

Rogoff cites Buiter’s research at the London School of Economics (LSE) which dates to a decade earler, but has been significantly revised in the 2009-10 timeframe.

The paper considers three methods for eliminating the zero lower bound on nominal interest rates and thus for restoring symmetry to domain over which the central bank can vary its policy rate. They are: (1) abolishing currency (which would also be a useful crime-fighting measure); (2) paying negative interest on currency by taxing currency; and (3) decoupling the numéraire from the currency/medium of exchange/means of payment and introducing an exchange rate between the numéraire and the currency which can be set to achieve a forward discount (expected depreciation) of the currency vis-a-vis the numéraire when the nominal interest rate in terms of the numéraire is set at a negative level for monetary policy purposes.

Buiter notes the “scrip” money developed locally during the Great Depression (also see Champ) effectively involved a tax on holding this type of currency.

Stamp scrip, sometimes called coupon scrip, arose in several communities. It was denominated in dollars, in denominations from 25 cents to $5, with $1 denominations most common. Stamp scrip often became redeemable by the issuer in official U.S. dollars after one year.

What made stamp scrip unique among scrip schemes was a series of boxes on the reverse side of the note. Stamp scrip took two basic forms—dated and undated (often called “transaction stamp scrip”). Typically, 52 boxes appeared on the back of dated stamp scrip, one for each week of the year. In order to spend the dated scrip, the stamps on the back had to be current. Each week, a two-cent stamp needed to be purchased from the issuer and affixed over the corresponding week’s box on the back of the scrip. Over the coming week, the scrip could be spent freely within the community. Whoever was caught holding the scrip at week’s end was required to attach a new stamp before spending the scrip. In this scheme, money became a hot potato, with individuals passing it quickly to avoid having to pay for the next stamp.

Among the virtues of eliminating paper currency and going entirely to electronic transactions, thus, would be that the central bank could charge a negative interest rate.

Additionally, by eliminating the anonymity of paper money and coin, criminal activities could be more effectively controlled. Rogoff offers calculations suggesting the percentages of US currency held in Europe in ratio to overall economic activity are suspicious, especially since there are apparently a surfeit of 100 dollar bills in these foreign holdings.

These ideas go considerably beyond the small negative interest charged by the ECB on banks holding excess reserves in the central bank accounts. What is being discussed is an extension of negative nominal interest, or a tax on holding cash, to all business agents and individuals in an economy.

Considering that social and systems analysis originated largely in Europe (Machiavelli, Vico, Max Weber, Emile Durkheim, Walras, Adam Smith and the English school of political economics, and so forth), it’s not surprising that any deep analysis of the current European situation is almost alarmingly complex, reticulate, and full of nuance.

However, numbers speak for themselves, to an extent, and I want to start with some basic facts about geography, institutions, and economy.

Then, I’d like to precis the current problem from an economic perspective, leaving the Ukraine conflict and its potential for destabilizing things for a later post.

Some Basic Facts About Europe and Its Institutions

But some basic facts, for orientation. The 2013 population of Europe, shown in the following map, is estimated at just above 740 million persons. This makes Europe a little over 10 percent of total global population.

The European Union (EU) includes 28 countries, as follows with their date of entry in parenthesis:

The single or ‘internal’ market is the EU’s main economic engine, enabling most goods, services, money and people to move freely. Another key objective is to develop this huge resource to ensure that Europeans can draw the maximum benefit from it.

There also are governing bodies which are headquartered for the most part in Brussels and administrative structures.

The Eurozone consists of 18 European Union countries which have adopted the euro as their common currency. These countries includes Belgium, Germany, Estonia, Ireland, Greece, Spain, France, Italy, Cyprus, Latvia, Luxembourg, Malta, the Netherlands, Austria, Portugal, Slovenia, Slovakia and Finland.

The European Central Bank (ECB) is located in Frankfurt, Germany and performs a number of central bank functions, but does not clearly state its mandate on its website, so far as I can discover. The ECB has a governing council comprised of representatives from Eurozone banking and finance circles.

According to the International Monetary Fund World Economic Outlook (July 14, 2013 update), the Eurozone accounts for an estimated 17 percent of global output, while the European Union countries comprise an estimated 24 percent of global output. By comparison the US accounts for 23 percent of global output, where all these percents are measured in terms of output in current US dollar equivalents.

What is the Problem?

I began engaging with Europe and its economic setup professionally, some years ago. The European market is important to information technology (IT) companies. Europe was a focus for me in 2008 and through the so-called Great Recession, when sharp drops in output occurred on both sides of the Atlantic. Then, after 2009 for several years, the impact of the global downturn continued to be felt in Europe, especially in the Eurozone, where there was alarm about the possible breakup of the Eurozone, defaults on sovereign debt, and massive banking failure.

I have written dozens of pages on European economic issues for circulation in business contexts. It’s hard to distill all this into a more current perspective, but I think the Greek economist Yanis Varoufakis does a fairly good job.

The first quote highlights the problems (and lure) of a common currency to a weaker economy, such as Greece.

Right from the beginning, the original signatories of the Treaty of Rome, the founding members of the European Economic Community, constituted an asymmetrical free trade zone….

To see the significance of this asymmetry, take as an example two countries, Germany and Greece today (or Italy back in the 1950s). Germany, features large oligopolistic manufacturing sectors that produce high-end consumption as well as capital goods, with significant economies of scale and large excess capacity which makes it hard for foreign competitors to enter its markets. The other, Greece for instance, produces next to no capital goods, is populated by a myriad tiny firms with low price-cost margins, and its industry has no capacity to deter competitors from entering.

By definition, a country like Germany can simply not generate enough domestic demand to absorb the products its capital intensive industry can produce and must, thus, export them to the country with the lower capital intensity that cannot produce these goods competitively. This causes a chronic trade surplus in Germany and a chronic trade deficit in Greece.

If the exchange rate is flexible, it will inevitably adjust, constantly devaluing the currency of the country with the lower price-cost margins and revaluing that of the more capital-intensive economy. But this is a problem for the elites of both nations. Germany’s industry is hampered by uncertainty regarding how many DMs it will receive for a BMW produced today and destined to be sold in Greece in, say, ten months. Similarly, the Greek elites are worried by the devaluation of the drachma because, every time the drachma devalues, their lovely homes in the Northern Suburbs of Athens, or indeed their yachts and other assets, lose value relative to similar assets in London and Paris (which is where they like to spend their excess cash). Additionally, Greek workers despise devaluation because it eats into every small pay rise they manage to extract from their employers. This explains the great lure of a common currency to Greeks and to Germans, to capitalists and labourers alike. It is why, despite the obvious pitfalls of the euro, whole nations are drawn to it like moths to the flame.

So there is a problem within the Eurozone of “recycling trade surpluses” basically from Germany and the stronger members to peripheral countries such as Greece, Portugal, Ireland, and even Spain – where Italy is almost a special, but very concerning case.

The next quote is from a section in MODEST PROPOSAL called “The Nature of the Eurozone Crisis.” It is is about as succinct an overview of the problem as I know of – without being excessively ideological.

The Eurozone crisis is unfolding on four interrelated domains.

Banking crisis: There is a common global banking crisis, which was sparked off mainly by the catastrophe in American finance. But the Eurozone has proved uniquely unable to cope with the disaster, and this is a problem of structure and governance. The Eurozone features a central bank with no government, and national governments with no supportive central bank, arrayed against a global network of mega-banks they cannot possibly supervise. Europe’s response has been to propose a full Banking Union – a bold measure in principle but one that threatens both delay and diversion from actions that are needed immediately.

Debt crisis: The credit crunch of 2008 revealed the Eurozone’s principle of perfectly separable public debts to be unworkable. Forced to create a bailout fund that did not violate the no-bailout clauses of the ECB charter and Lisbon Treaty, Europe created the temporary European Financial Stability Facility (EFSF) and then the permanent European Stability Mechanism (ESM). The creation of these new institutions met the immediate funding needs of several member-states, but retained the flawed principle of separable public debts and so could not contain the crisis. One sovereign state, Cyprus, has now de facto gone bankrupt, imposing capital controls even while remaining inside the euro.

During the summer of 2012, the ECB came up with another approach: the Outright Monetary Transactions’ Programme (OMT). OMT succeeded in calming the bond markets for a while. But it too fails as a solution to the crisis, because it is based on a threat against bond markets that cannot remain credible over time.

And while it puts the public debt crisis on hold, it fails to reverse it; ECB bond purchases cannot restore the lending power of failed markets or the borrowing power of failing governments.

Investment crisis: Lack of investment in Europe threatens its living standards and its international competitiveness. As Germany alone ran large surpluses after 2000, the resulting trade imbalances ensured that when crisis hit in 2008, the deficit zones would collapse. And the burden of adjustment fell exactly on the deficit zones, which could not bear it. Nor could it be offset by devaluation or new public spending, so the scene was set for disinvestment in the regions that needed investment the most.

Thus, Europe ended up with both low total investment and an even more uneven distribution of that investment between its surplus and deficit regions.

Social crisis: Three years of harsh austerity have taken their toll on Europe’s peoples. From Athens to Dublin and from Lisbon to Eastern Germany, millions of Europeans have lost access to basic goods and dignity. Unemployment is rampant. Homelessness and hunger are rising. Pensions have been cut; taxes on necessities meanwhile continue to rise. For the first time in two generations, Europeans are questioning the European project, while nationalism, and even Nazi parties, are gaining strength.

This is from a white paper jointly authored by Yanis Varoufakis, Stuart Holland and James K. Galbraith which offers a rationale and proposal for a European “New Deal.” In other words, take advantage of the record low global interest rates and build infrastructure.

The passage covers quite a bit of ground without appearing to be comprehensive. However, it will be be a good guide to check, I think, if a significant downturn unfolds in the next few quarters. Some of the nuances will come to life, as flaws in original band-aid solutions get painfully uncovered.

Now there is no avoiding some type of ideological or political stance in commenting on these issues, but the future is the real question. What will happen if a recession takes hold in the next few quarters?

More on European Banks

European banks have been significantly under-capitalized, as the following graphic from before the Great Recession highlights.

If a recession unfolds in the next few quarters, it is likely to significantly impact the European economy, opening up old wounds, so to speak, wounds covered with band-aid solutions. I know I have not proven this assertion in this post, but it is a message I want to convey.

The banking sector is probably where the problems will first flare up, since banks have significant holdings of sovereign debt from EU states that already are on the ropes – like Greece, Spain, Portugal, and Italy. There also appears to be some evidence of froth in some housing markets, with record low interest rates and the special conditions in the UK.

Hopefully, the global economy can side-step this current wobble from the first quarter 2014 and maybe even further in some quarters, and somehow sustain positive or at least zero growth for a few years.

All because the basic numbers for major European economies, including notably Germany and France (as well as long-time problem countries such as Spain), are not good. Growth has stalled or is reversing, bank lending is falling, and deflation stalks the European markets.

Europe – which, of course, is sectored into the countries inside and outside the currency union, countries in the common market, and countries in none of the above – accounts for several hundred million persons and maybe 20-30 percent of global production.

So what happens there is significant.

Then there is the Ukraine crisis.

Zerohedge ran this graphic recently showing the dependence of European countries on gas from Russia.

The US-led program of imposing sanctions on Russia – key individuals, companies, banks perhaps – flies in the face of the physical dependence of Germany, for example, on Russian gas.

On the other hand, there is lots of history here on all sides, including, notably, the countries formerly in the USSR in eastern Europe, who no doubt fear the increasingly nationalistic or militant stance shown by Russia currently in, for example, re-acquiring Crimea.

As Chancellor Merkel has stressed, this is an area for diplomacy and negotiation – although there are other voices and forces ready to rush more weapons and even troops to the region of conflict.

Finally, as I have been stressing from time to time, there is an emerging demographic reality which many European nations have to confront.

Edward Hugh has several salient posts on possibly overlooked impacts of aging on the various macroeconomies involved.

There also is the vote on Scotland coming up in the United Kingdom (what we may, if the “yes” votes carry, need to start calling “the British Isles.”)

I’d like to keep current with the signals coming from Europe in a few blogs upcoming – to see, for example, whether swing events in the next six months to a year could originate there.

I’m planning posts on forecasting the price of gold this week. This is an introductory post.

The Question of Price

What is the “price” of gold, or, rather, is there a single, integrated global gold market?

This is partly an anthropological question. Clearly in some locales, perhaps in rural India, people bring their gold jewelry to some local merchant or craftsman, and get widely varying prices. Presumably, though this merchant negotiates with a broker in a larger city of India, and trades at prices which converge to some global average. Very similar considerations apply to interest rates, which are significantly higher at pawnbrokers and so forth.

The Wikipedia article on gold fixing recounts the history of this twice daily price setting, dating back, with breaks for wars, to 1919.

One thing is clear, however. The “price of gold” varies with the currency unit in which it is stated. The World Gold Council, for example, supplies extensive historical data upon registering with them. Here is a chart of the monthly gold prices based on the PM or afternoon fix, dating back to 1970.

Another insight from this chart is that the price of gold may be correlated with the price of oil, which also ramped up at the end of the 1970’s and again in 2007, recovering quickly from the Great Recession in 2008-09 to surge up again by 2010-11.

These tables give an idea of the main components of gold supply and demand over a several years recently.

Gold is an unusual commodity in that one of its primary demand components – jewelry – can contribute to the supply-side. Thus, gold is in some sense renewable and recyclable.

Table 1 above shows the annual supplies in this period in the last decade ran on the order of three to four thousand tonnes, where a tonne is 2,240 pounds and equal conveniently to 1000 kilograms.

Demand for jewelry is a good proportion of this annual supply, with demands by ETF’s or exchange traded funds rising rapidly in this period. The industrial and dental demand is an order of magnitude lower and steady.

One of the basic distinctions is between the monetary versus nonmonetary uses or demands for gold.

In total, central banks held about 30,000 tonnes of gold as reserves in 2008.

Another estimated 30,000 tonnes was held in inventory for industrial uses, with a whopping 100,000 tonnes being held as jewelry.

India and China constitute the largest single countries in terms of consumer holdings of gold, where it clearly functions as a store of value and hedge against uncertainty.

Gold Market Activity

In addition to actual purchases of gold, there are gold futures. The CME Group hosts a website with gold future listings. The site states,

Gold futures are hedging tools for commercial producers and users of gold. They also provide global gold price discovery and opportunities for portfolio diversification. In addition, they: Offer ongoing trading opportunities, since gold prices respond quickly to political and economic events, Serve as an alternative to investing in gold bullion, coins, and mining stocks

Some of these contracts are recorded at exchanges, but it seems the bulk of them are over-the-counter.

A study by the London Bullion Market Association estimates that 10.9bn ounces of gold, worth $15,200bn, changed hands in the first quarter of 2011 just in London’s markets. That’s 125 times the annual output of the world’s gold mines – and twice the quantity of gold that has ever been mined.

The Forecasting Problem

The forecasting problem for gold prices, accordingly, is complex. Extant series for gold prices do exist and underpin a lot of the market activity at central exchanges, but the total volume of contracts and gold exchanging hands is many times the actual physical quantity of the product. And there is a definite political dimension to gold pricing, because of the monetary uses of gold and the actions of central banks increasing and decreasing their reserves.

But the standard approaches to the forecasting problem are the same as can be witnessed in any number of other markets. These include the usual time series methods, focused around arima or autoregressive moving average models and multivariate regression models. More up-to-date tactics revolve around tests of cointegration of time series and VAR models. And, of course, one of the fundamental questions is whether gold prices in their many incarnations are best considered to be a random walk.

This offers a fascinating overview of supply and demand in global gold markets and an immediate prediction –

This “gold as a commodity” framework suggests that gold prices have strong support at and above current price levels should the current low real interest rate environment persist. Specifically, assuming real interest rates stay near current levels and the buying from gold-ETFs slows to last year’s pace, we would expect to see gold prices stay near $930/toz over the next six months, rising to $962/toz on a 12-month horizon.

Now, of course, the real interest rate is an inflation-adjusted nominal interest rate. It’s usually estimated as a difference between some representative interest rate and relevant rate of inflation. Thus, the real interest rates in the Goldman Sachs report is really an extrapolation from extant data provided, for example, by the US Federal Reserve FRED database.

The graph shows that “real interest rates stay near current levels” (from spring 2009), putting the Goldman Sachs group authoring Report No 183 on record as producing one of the most successful longer term forecasts that you can find.

I’ve been collecting materials on forecasting systems for gold prices, and hope to visit that topic in coming posts here.

There seems to be a meme evolving around the idea that – while the official business outlook for 2014 is positive – problems with Chinese debt, or more generally, emerging markets could be the spoiler.

The encouraging forecasts posted by bank and financial economists (see Hatzius, for example) present 2014 as a balance of forces, with things tipping in the direction of faster growth in the US and Europe. Austerity constraints, sequestration in the US and draconian EU policies, will loosen, allowing the natural robustness of the underlying economy to assert itself – after years of sub-par performance. In the meanwhile, growth in the emerging economies is admittedly slowing, but is still is expected at much higher rates than in heartland areas of the industrial West or Japan.

So, fingers crossed, the World Bank and other official economic forecasting agencies show an uptick in economic growth in the US and, even, Europe for 2014.

But then we have articles that highlight emerging market risks:

China’s debtfuelled boom is in danger of turning to bust This Financial Times article develops the idea that only five developing countries have had a credit boom nearly as big as China’s, in each case leading to a credit crisis and slowdown. So currently Chinese “total debt” – a concept not well-defined in this short piece – is currently running about 230 per cent of gross domestic product. The article offers comparison with “33 previous credit binges” and to smaller economies, such as Taiwan, Thailand, Zimbabwe, and so forth. Strident, but not compelling.

With China Awash in Money, Leaders Start to Weigh Raising the Floodgates From the New York Times, a more solid discussion – The amount of money sloshing around China’s economy, according to a broad measure that is closely watched here, has now tripled since the end of 2006. China’s tidal wave of money has powered the economy to new heights, but it has also helped drive asset prices through the roof. Housing prices have soared, feeding fears of a bubble while leaving many ordinary Chinese feeling poor and left out.

The People’s Bank of China has been creating money to a considerable extent by issuing more renminbi to bankroll its purchase of hundreds of billions of dollars a year in currency markets to minimize the appreciation of the renminbi against the dollar and keep Chinese exports inexpensive in foreign markets; the central bank disclosed on Wednesday that the country’s foreign reserves, mostly dollars, soared $508.4 billion last year, a record increase.

Moreover, the rapidly expanding money supply reflects a flood of loans from the banking system and the so-called shadow banking system that have kept afloat many inefficient state-owned enterprises and bankrolled the construction of huge overcapacity in the manufacturing sector.

There also are two at least two recent, relevant posts by Yves Smith – who is always on the watch for sources of instability in the banking system

So there are causes for concern, especially with the US Fed, under Janet Yellen, planning on winding down QE or quantitative easing.

When Easy Money Ends is a good read in this regard, highlighting the current scale of QE (quantitative easing) programs globally, and savings from lower interest rates – coupled with impacts of higher interest rates.

Since the start of the financial crisis, the Fed, the European Central Bank, the Bank of England, and the Bank of Japan have used QE to inject more than $4 trillion of additional liquidity into their economies…If interest rates were to return to 2007 levels, interest payments on government debt could rise by 20%, other things being equal…US and European nonfinancial corporations saved $710 billion from lower debt-service payments, with ultralow interest rates thus boosting profits by about 5% in the US and the UK, and by 3% in the euro-zone. This source of profit growth will disappear as interest rates rise, and some firms will need to reconsider business models – for example, private equity – that rely on cheap capital…We could also witness the return of asset-price bubbles in some sectors, especially real estate, if QE continues. The International Monetary Fund noted in 2013 that there were already “signs of overheating in real-estate markets” in Europe, Canada, and some emerging-market economies.